How to set up your first 401(k): A step-by-step guide

ConstanceBrinkley-Badgett

So you’ve decided to save for your retirement using your company’s 401(k) plan. Congratulations! It’s a great way to save. But now what? Which funds do you choose? How much should you contribute? Are there limits? How do your employer’s matching funds actually work? Can you access the money if you need it before retirement?

Obviously, there are a lot of questions that can arise when it comes time to set up your retirement savings, but we’re here to help. Here’s what you need to know to set up your 401(k).

What Is a 401(k)?

The section of the U.S. tax code that describes these retirement savings plans is Section 401(k), thus the name. These plans let you invest pre-tax dollars directly from your salary, along with any additional investment made by your employer. Unlike an individual retirement account, or IRA, 401(k)s are sponsored by employers, and, if offered at all, they must be made available to all employees of the company sponsoring the 401(k).

Your employer does have the right to impose a couple of restrictions, however. 1. They can require that you work full-time for a period of time before eligibility, and 2. can also stipulate that you be at least 21 years old before enrolling. That’s why it’s always good to ask about eligibility when interviewing for a new job.

You choose your investments

Most 401(k) accounts are self-directed. That means you choose where to put your money from a list of funds made available through your 401(k) plan provider (Vanguard and Fidelity are two of the larger firms providing 401(k) funds). This can get tricky. Do you choose the safest investments that offer little risk but less reward? Do you opt for high growth? Targeted funds? Emerging market funds? What about bonds?

Obviously, you’re going to want to do some research, perhaps even talk to someone with some expertise. Most plan providers share details about the individual funds they offer on their websites, or at least have links to more details. Some even offer tools to help you choose which funds fit your needs, while others make real live people available for limited consultations. Seek out the assistance you need to fully understand what you’re doing with your savings.

You also choose how much to save

There’s really no correct answer when it comes to how much to save, but certainly, saving as much as you can for retirement is a good idea. And if your employer offers matching funds (free money) for your investments, you’ll at least want to invest the full amount they match. So, for example, if your employer matches up to 3% of your salary, you’ll want to invest at least 3%, though certainly you can invest more. Here are some tips on how to maximize your 401(k).

But there are limits

Federal law allows investors to put up to $18,000 into a 401(k) each year unless you’re over age 50, when you’re allowed to make an additional $6,000 in “catch-up” contributions.

If you’re in the lucky position of being able to save more than these limits, there are investing alternatives to your 401(k) that you may want to consider. These include IRAs, certificates of deposit (CDs) and even individual stocks if you’re familiar enough with the markets.

You can’t use your money

Keep in mind that a 401(k) isn’t like a savings account. But for a few exceptions, you can’t withdraw your money before age 59½ without paying early withdrawal penalties and taxes. You can take a loan against your 401(k) if your employer’s plan allows for that, but only for specific purposes like education, medical reasons or first-time home purchases. Your repayments will come right out of your paycheck, making the process simple, but there are some dangers you’ll want to consider before borrowing against your 401(k).

If you’re just starting out in the investing/saving world, you may want to consider putting a portion of your income toward an emergency fund that is easily accessed, carries no penalties and can get you out of a jam, like a giant car repair bill, when you need it.

But you can take it with you

To another job, that is. When you leave, you won’t lose your investments, though you could lose contributions made by your employer. That’s because some employers require a “vesting period” for their contributions to your 401(k). Essentially, it means you have to work for the company for a predetermined period of time before you can claim what they’ve given you.

When you leave, you simply set up a rollover IRA with your plan provider. Those funds can then either stay put in the IRA or be rolled over to your 401K with your new employer. You’ll want to compare the income history for the funds before deciding where the money will best serve you.

Retirement may feel eons away, but it pays (quite literally) to start early. Fortunately, we’ve got a full list of 50 things millennials can do now to retire at 65.

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